Part III   Law Firms

8   The Texas Juggernaut

In January 1998 the National Law Journal ran a front page article celebrating the rapid ascent of the Dallas-based law firm Jenkens & Gilchrist. Under the leadership of its chief executive David Laney, the firm had grown over the preceding three years from 160 to 340 lawyers. The article identified Jenkens as the fastest-growing law firm in the United States and described it as a “juggernaut.”¹ The article noted the firm’s addition of practice groups from other firms as the basis for its growth, saying that Laney “inspired these lawyers to dream Texas-size dreams.”² It suggested that “being rewarded for rain appears to be what lured many newcomers,”³ quoting one lateral hire’s dissatisfaction with other firms that compensated lawyers based on seniority. Another attraction of the firm was that branch offices set their own budgets, decided in which areas to specialize, and made associate hiring decisions independent of Dallas.

For many at the firm, the next challenge was to “develop a national presence.”⁴ Jenkens & Gilchrist’s board of directors was investigating the possibility of entering the New York market and the head of the intellectual property practice said that the firm almost certainly would be moving into the Silicon Valley. “He has expectations of us being the largest technology ‘boutique’ in the country,” the lawyer said of Laney. “David Laney doesn’t stop at being No. 10.”⁵ At the beginning of 1998, Jenkens & Gilchrist epitomized the law firm of the twenty-first century: restless, entrepreneurial, and focused on constant growth as the core of its competitive strategy.

Later that same year, the firm continued its aggressive strategy by hiring Paul Daugerdas as a lateral partner to open its Chicago office. Daugerdas, who brought with him a handful of colleagues from Altheimer & Gray, had a lucrative practice built around designing and selling tax shelters. After vigorous internal debate about whether Daugerdas’s aggressive tax practice was a good fit for the firm, Jenkens decided to hire him. The move paid off handsomely. From 1999 through 2002, Jenkens & Gilchrist received well over $200 million in fees from tax shelter work done by Daugerdas and his Chicago colleagues.

A major national firm like Jenkens almost certainly would not have entertained the idea of hiring someone like Daugerdas a decade earlier. The elite tax bar considered lawyers who worked on tax shelters to be suspect, not worthy of being considered true professionals. With intensified competitive pressures, the consensus about the norms that governed tax practice had begun to disintegrate, and a divide had arisen in the tax bar about where the line between an aggressive tax strategy and an abusive tax shelter was located. With the acquisition of Daugerdas, Jenkens became the most prominent law firm to push the boundary in the new tax shelter industry.

Jenkens & Gilchrist: Rise, Fall, and Rise

Jenkens & Gilchrist was founded in 1951 by Holman Jenkens and William H. Bowen. Jenkens had served since 1946 as the personal lawyer of Clint Murchison, Jr. The Murchison family was active in the oil business and other ventures, and Clint Murchison was an influential member of Dallas society. The firm’s stable long-term relationship with the Murchison family was a typical feature of law firm practice in the mid-twentieth century.

Although it expanded as the Texas economy grew, Jenkens & Gilchrist was a small high-end firm that expected to stay relatively small. By 1985, the firm had grown to 125 lawyers, but 20 to 30 percent of its business still came from the Murchisons. The firm was known as collegial and friendly. It typically did not cut the compensation of lawyers whose billable hours fell temporarily due to marital or health problems. In this respect, the firm was similar to others during the period whose stable client base and insulation from stiff competition allowed them to avoid relying on financial considerations as the driving force of their decisions.

Jenkens & Gilchrist’s halcyon existence was destroyed in the mid-1980s with a sharp decline in the Texas economy provoked by failures in the energy, real estate, banking, and savings and loan sectors. The firm also faced litigation by the Federal Savings & Loan Insurance Corporation (FSLIC) over its representation of two savings and loans that had failed. In addition, it was a defendant in a lawsuit by twenty-six investors who had lost money from participation in a failed oil project that the firm had assisted in making a private stock offering in 1981. The firm settled with the FSLIC for $18 million in 1989 and was found liable for just under $6 million in damages in the investor lawsuit.

The combination of the business downturn and legal troubles left Jenkens in a precarious position. The firm had cultivated a client base of influential companies and wealthy individuals in Dallas. To a large degree, its practice was organized around clients at least as much as around practice areas. The firm provided a wide range of services for these clients. This client-oriented organization and the firm’s relative insulation from significant competition meant that Jenkens’s leaders likely spent little time thinking of the firm’s market position.

By the end of the 1980s, however, this business model was no longer viable. The firm could no longer focus its work on a single geographic market or in a limited number of industries. Nor could it count on long-term relationships with clients any more, since corporations had begun to sever exclusive relationships with firms to foster competition for their legal work. Jenkens was also handicapped in moving forward because authority was dispersed within a large executive committee. As a result, many in the firm were uncertain whether it could survive.

Faced with the possible demise of Jenkens & Gilchrist, a group of young partners sought to develop a strategy that addressed the firm’s predicament. The first priority was revising the governance structure. The firm became a professional corporation, its partners the shareholders.⁶ This limited the financial liability of the firm’s principals for its obligations. Jenkens adopted a three-person executive committee (later expanded to five) and a strong-president model. The executive committee would be advised by an electoral committee consisting of the heads of major practice groups.

At the end of 1989, forty-one-year-old David Laney became president of Jenkens & Gilchrist. Laney was from a prominent Dallas family. His father for many years was head of the major Dallas law firm now known as Locke, Liddell & Sapp and his mother was the granddaughter of the founder of the Dallas Morning News. Laney was deeply involved in folk music and sports growing up and counted as one of his high school classmates the actor Tommy Lee Jones. He graduated from Stanford University, where he played football his first two years, enrolled in the doctoral program in American Studies at Brown University, but then decided instead to attend law school at Southern Methodist University.

On assuming the firm’s leadership, Laney began to chart a course he believed would enable Jenkens & Gilchrist to succeed in the new legal services market. One objective was to diversify both geographically and in practice areas. Another was to identify and expand those practices that were likely to be most lucrative. Under Laney, the firm undertook to revise its compensation to compete more effectively with the large Houston firms. The last goal was a challenge because Dallas for the most part had a “mid-market” client base. Companies generally were not as large, diverse, and prosperous as those in Houston. This meant that Dallas firms were often unable to bill at rates as high as Houston firms’ because their clients simply could not afford this. In turn this constrained Jenkens & Gilchrist in compensating its lawyers.

The next step in remaking the firm was to let go one-fourth of its lawyers—reducing the total from 225 to 165. Laney later reflected, “It was a low point, one of the lowest in my life, but for the firm, it was a galvanizing point, and in retrospect, inescapable.”⁷ The firm started to recruit lawyers from other firms who practiced in intellectual property, construction and government contracts, franchise law, health law, government relations, and tort litigation, all areas in which the firm anticipated significant growth. The intellectual property practice area was especially profitable and represented a movement into at least a high niche in the mid-tier market. By 1998, the firm had increased the number of lawyers in this field to seventy, compared with just five in 1994.

Through much of the 1990s, Jenkens & Gilchrist acquired practice groups of various sizes, expanding beyond Dallas and then beyond Texas. In 1992, Jenkens opened a Washington, D.C. office and in 1997 it opened one in Los Angeles. In 1996, Jenkens moved into the American Lawyer’s Am Law 100 in gross revenue and profits per partner, ranking 98 and 64 in these categories. By 1998, the firm moved to 68 in the National Law Journal ranking of the largest 250 firms in the country, up from 166 in 1994. In its prominent front page article, the publication noted the firm’s rapid growth, aggressive lateral recruiting, and big ambitions.

When the National Law Journal profile of the firm appeared in 1998, Jenkens was a regional firm with national aspirations. Like most regional firms, most of its work was for medium-size corporate clients at rates lower than those in major legal centers like New York and Washington. At the same time, some of its intellectual property litigation conceivably could involve higher-end work. The desire to diversify had led the firm to feature a total of thirteen practice groups by 1998. Some of those likely were not as profitable as intellectual property, but they generated revenues and were a hedge against falling victim to reliance on too narrow a practice base. Jenkens thus pursued a strategy of strengthening and diversifying its existing practices, while looking to add lawyers in practice areas and locations that might give it access to more complex work at higher rates.

The legal services market in Dallas was especially robust at this time, but there was strong competition from peer firms in the city that were following a similar business strategy. The belief was that firms had to grow quickly to survive. This meant that acquiring laterals, rather than growing from within, was the best way to diversify and expand the firm’s economic base. The firm made itself attractive to laterals by insisting on merit-based compensation that rewarded business generation. Because of intense competition in the regional market, expansion beyond Texas and the Southwest was important.

Crucial to success in the lateral market were the firm’s profits per partner (PPP). If Jenkens were to become a national firm, this figure had to keep increasing. Recruits automatically asked the firm about its balance sheet and profits when considering an offer to relocate to Jenkens. If the firm hoped to crack the New York market, keeping PPP up would be especially important, given the profitability of firms in that market.

The most recent figures from the American Lawyer at that time indicated that the firm ranked 84 in the Am Law 100 in gross revenues in 1997, posting a 30.6 percent increase over the previous year. This was the third-highest gain among Am Law 100 firms. But the firm’s PPP was less reassuring. By the end of 1998, when Jenkens & Gilchrist leadership was considering whether to extend an offer to Daugerdas, the firm was about to close the books on a year in which it would drop from 75 to 79 in the Am Law 100 with profits per partner of $390,000. This figure was only 0.3 percent larger than in 1997. More troubling, the gap between the Am Law 100 average firm’s PPP and Jenkens’s had increased during the year from $212,000 to $232,000.

In its description of the 1998 Texas legal services market, the American Lawyer noted that increasing competition was coming from out-of-state firms. “The past few years have been a period of consolidation,” said the publication, “as firms look to beef up their ranks in order to compete.”⁸ During the year, Locke Purnell Rain Harrell of Dallas and Liddell, Sapp, Zivley, Hill & LaBoon of Houston had merged to create the fifth largest firm in the state. Its combined revenue would have ranked it in the Am Law 100 for 1998. Boosting profits at Jenkens & Gilchrist thus was critical in order to fund the continued growth that was seen as necessary for survival in a consolidating market.

At this point, Jenkens & Gilchrist was a very successful firm by many standards. It was one of only two Dallas-based firms in the Am Law 100. It had weathered the crisis of the late 1980s and embarked on a path of substantial growth in size and revenues. For Jenkens to compete on a national stage, however, this was not enough. It had to figure out a way to boost profits per partner so that it could compete for laterals with other Am Law 100 firms, as well as defend itself from firms seeking to raid its own partners.

Offering Shelter

Paul Daugerdas had come from Arthur Andersen to the law firm of Altheimer & Gray in 1994 at the age of forty-seven with a salary of $350,000 and a goal to transform the firm’s tax practice into a major source of revenue from tax shelter products. By 1998, he had succeeded. The stocky lawyer and CPA with a blonde mustache earned $1 million that year and generated considerably more than that in revenues. He did not feel that he was adequately compensated for his work, however. He had understood when he came to Altheimer that he had an agreement with the firm’s steering committee that he would receive 50 percent of all “premium” billing based on a percentage of the taxes that each shelter saved a client. By his calculations, the steering committee had not honored that promise. In fact, the firm had some concerns about the magnitude of the revenues he was generating and conducted an inquiry into whether they posed an unacceptable risk for the firm. Daugerdas was not shy about voicing his displeasure about his compensation and the firm’s concerns about his practice. When he concluded that the firm was unlikely to be responsive to his dissatisfaction, Daugerdas began to seek opportunities elsewhere.

The practices of two Altheimer partners were closely tied to Daugerdas. Tax partner Donna Guerin, petite, dark-haired, and somewhat retiring, was also both a lawyer and a certified public accountant. She performed much of the technical work for the clients Daugerdas brought to the firm. This involved activities such as creating various business entities and preparing opinions that addressed the likelihood that a client’s tax treatment of a shelter transaction would prevail. Erwin Mayer had been in the estate planning group at Altheimer. The boyish-looking partner sometimes commuted to work with Guerin, and they often had lunch together. Mayer became intrigued by Guerin’s description of the tax shelter work she was doing and in 1995 began introducing some of his clients to Daugerdas. He learned the mechanics of the transactions and their necessary documentation. By 1998, unlike Guerin, he had become a major source of clients in his own right. When Mayer learned that Daugerdas was considering leaving Altheimer, he assumed that Guerin would go with him. He made clear to Daugerdas that he would like to do the same.

Daugerdas approached the firm through an intermediary, a former colleague at Altheimer who had read the National Law Journal article on Jenkens and hoped that the firm would be interested in both Daugerdas’s tax practice and his own international law practice. He called Laney and told him Daugeredas helped high-net-worth individuals shelter their income through cutting-edge tax strategies. This was the kind of sophisticated high-end practice that could be a boon to Jenkens.

Laney received calls like this all the time because of the firm’s growing profile. This call had particular appeal for several reasons. First, Chicago was an attractive market in which to expand because it had a lot of mid-market clients and firms with rate structures comparable to Jenkens’s. The firm had not made much headway in Washington, D.C., because it did not have a niche regulatory practice. It had moved into Los Angeles but talks with firms in San Francisco had not yielded anything. The firm had considered Atlanta but found that market oriented mainly to the East Coast corridor from Boston to Washington. It had considered London and was looking at New York but needed higher profits per partner to compete in those high-end markets. Chicago, in other words, could be a good fit.

Daugerdas’s practice could be valuable to Jenkens for another reason. Its focus on high-wealth clients could provide the boost in prestige and profits per partner that could attract other laterals who brought high-value work with higher margins than the firm usually enjoyed. This could help enable the firm to enter New York, a step that would validate its claim to be a national law firm. Ideally, it also would enable Jenkens to be less reliant on mid-market clients who were sensitive to billing rates. The firm’s leaders were convinced that expanding its geographic and practice scope was necessary to respond to increasing competition from both law and accounting firms.

Finally, bringing Daugerdas into the firm would help further the aim of doing more high-end work for which cost containment was not the predominant concern. Not many firms could find such opportunities, especially regional firms whose work was subject to a fair amount of price competition. Daugerdas’s practice, with fees based on a percentage of tax savings, effectively provided Jenkens with work based on a version of value billing. It had an appealing combination of features.

First, fees were based on a percentage of the value of a matter rather than hourly rates. For this work, the firm therefore could escape the constraints of the billable hour and reap a share of the financial benefits that it made available to clients. In this respect, tax shelter billing represented a version of what elite firms like Wachtell Lipton did when they charged a fee based on the value of a merger or acquisition.

Second, after a tax shelter opinion was created, it could be recycled for the same type of transaction sold to other taxpayers. The cost of producing the opinion for future transactions was negligible, while the fee as a percentage of tax savings could be substantial. In this respect, the firm would be able to use value billing on transactions that had become routine commodities. The firm would enjoy the benefits that came from high-end practice. At the same time, it did not have to incur the cost of designing customized solutions for every client, as did elite firms engaged in work at the top of the value pyramid.

A third feature of tax shelter opinions was designed to insulate them from the competitive pressures of the legal services life cycle that push toward the commoditization of legal work. While higher-end work is subject to the least amount of pressure to minimize costs, firms still find it difficult to avoid the legal services life cycle altogether. A firm that develops a cutting-edge strategy for a transaction, for instance, can’t keep that work confidential. It discloses the details of its innovation when it distributes documents to the other parties involved in the deal. As the information becomes more widely known, competitors look for ways to provide the same service more cheaply or to develop superior innovations. The result is that the original firm may enjoy only a brief period when it reaps the lion’s share of benefits from its creativity.

Daugerdas’s tax shelter arrangements sought to avoid this dynamic by restricting information about the terms of the shelters. Clients were prohibited from sharing information about the shelter on the grounds that it was a trade secret and were forbidden to consult any lawyer other than the one recommended by the tax shelter designers. As a result, potential competitors were deprived of the information they needed to compete on the basis of cost-efficiency and price. Indeed, there was some talk of trying to patent the transactions. In any event, treating them as trade secrets prevented what was essentially a commodity service from being priced as one.

Daugerdas therefore had particular allure for Jenkens as a profitable lateral who could provide the firm some respite from the fee reduction pressures to which mid-tier firms are subject. His tax shelter practice, in other words, offered Jenkens a possible path across the great market divide.

Laney asked board member William Durbin to follow up the lead about Daugerdas. Durbin had come to the firm from St. Louis as a young associate and worked in a bank lending practice that had been steady but not especially robust. Durbin shared the vision of Jenkens as a major player in the law firm world. He devoted considerable attention to the firm’s revenues and had a poster of the American Lawyer Top 100 law firms on the wall near his desk. As one former partner recalls, Durbin “would say that a law firm’s stock price is its profits per partner.”⁹ Durbin has acknowledged, “I had a reputation for being bottom line oriented.”¹⁰ Part of his job was to locate and help recruit promising lateral lawyers and practice groups to the firm.

Durbin also had his sights on Laney’s job. He had been on the board’s executive committee in the mid-1990s and continued to be involved in management once he left. He was trying to build a power base within the firm to launch a challenge to Laney and hoped to rely on lateral partners as a source of support. Although Laney was aware of Durbin’s aspirations, he did not realize how actively Durbin was building a constituency within the firm. There was no love lost between the two, and Laney may have put Durbin in charge of the Daugerdas project so that he would be held responsible if the venture failed. What Laney may not have anticipated was how much Daugerdas’s practice would boost Durbin’s stature when it became substantially more profitable than anyone had imagined.

While the firm had a strong tax practice, it had lost some lawyers so a new tax partner might strengthen that group. Laney suggested to Durbin that he consult with tax partners about Daugerdas’s practice. He felt that they would not hesitate to ask any necessary unpleasant questions about what Daugerdas was doing.

Laney was right on that score. Durbin set up a meeting among Daugerdas, a key tax partner, and himself. The partner found Daugerdas overbearing and arrogant, quick to promote his own talents and belittle those of others. Daugerdas said that he wanted to join the firm as a professional corporation, a move that, as it later turned out, was a vehicle for using tax shelters to wipe out tax liability for his income from the firm. Mitchell told him that the firm’s articles required that partners be individuals rather than organizations. Daugerdas responded that the firm had to change its articles to accommodate him. By the end of the conversation, the Jenkens tax lawyer still needed to do more analysis of Daugerdas’s practice but he had definite doubts about his suitability as a colleague.

The process for hiring laterals at Jenkens provided a role for both the board and the electoral committee. The committee at the time was composed of a little over twenty partners elected by their respective practice groups. The board would make the ultimate decision but the electoral committee offered advice. The latter was influential enough that the board generally was disinclined to move ahead without endorsement of a decision by the committee.

Daugerdas made his pitch to the board and committee. He described Currency Options Bring Reward Alternatives (COBRA), the tax shelter described in chapter 6 that was subsequently marketed with E&Y. He estimated that he would be able to generate $6 to 8 million in annual revenues by charging wealthy clients a percentage of the taxes they saved. This form of premium billing was a rarity at Jenkens, where hourly billing produced the overwhelming share of income. Considering the amount of work required to market the shelter and document the transactions comprising it, the profit margin on this activity was well above any other practice area at the firm. The economics of this practice and the opportunity it offered to expand to Chicago made Daugerdas and his colleagues an attractive practice group for Jenkens to acquire.

Daugerdas’s presentation nonetheless raised concerns among several partners, especially those on the electoral committee. Some were concerned that his business model simply seemed too good to be true. For a minimal amount of work, a given matter could generate tens or even hundreds of thousands of dollars. If this practice was so profitable, why weren’t more firms doing it—and why was Altheimer willing to let Daugerdas walk away? The two partners in charge of risk management for the firm suggested that even if the shelters technically were defensible under the letter of the tax law, they could be highly risky. The work had the potential to create tensions either with clients or with the government if questions were raised about the legality of the shelters and the firm’s advice in support of them. Publicity from such challenges could damage the firm’s reputation, lessen its credibility with the government, and perhaps even lead to aiding and abetting liability.

Some partners had reservations because they believed that Daugerdas was not really enhancing the firm’s ability to provide legal services. It was clear that he was not selling himself on the basis of his tax expertise but on the fact that he had a “product” to market. His work would not expand the scope of the firm’s tax practice. Instead, it was a world unto itself that happened to touch upon the tax law. As one former partner recalled, “It had nothing to do in my mind with practicing law.” Yes, the margins were impressive, but he noted: “My concern was, well, the margins on Slurpees are pretty good too; are we going to start selling Slurpees?”

The reaction among tax lawyers to Daugerdas’s practice was mixed. Some noted that respectable accounting firms were designing and selling similar shelters, that COBRA appeared to conform to the letter of the tax code, and that in any event the line between a valid and invalid shelter had always been ambiguous. While a taxpayer could not plausibly claim a profit motive from entering into the transactions if legal costs were taken into account, it was not entirely clear whether such fees should enter into the calculation. At the time, there were no IRS interpretations or court decisions that clearly precluded the tax consequences that taxpayers claimed as a result of the shelter. The firm therefore had a plausible defense of its position if its work were ever challenged.

Other tax partners, however, were highly critical of Daugerdas and his shelter practice. The work was novel, unprecedented, and very technical. Evaluating the legitimacy of a shelter required immersion in complex sections of the tax law that typically were not analyzed together in ordinary tax practice. The firm had no one who had done work in this area who could provide meaningful review. In addition, assessing the validity of a shelter required intimate familiarity with a particular taxpayer’s financial situation and the suitability of a given set of transactions to accomplish a client’s business objectives. Was the firm prepared to allow Daugerdas to make those calls on his own? If not, who would be able to spare the time to conduct the kind of monitoring that would be necessary—and would Daugerdas be cooperative with any such effort? The last question raised a more fundamental one: would Daugerdas be a genuine colleague or effectively a solo practitioner?

One tax partner had especially strong feelings about these concerns and took the lead in articulating them in a presentation to the board and electoral committee. He knew how time-consuming reviewing a tax shelter could be since he had analyzed one in response to a client’s request. Although he was an accomplished tax lawyer, the process still took more than fifty hours. Even then, although there was technical support for each step in the transaction, he couldn’t confidently tell the client whether an opinion was likely to be effective in avoiding penalties. Advising clients on whether engaging in the transaction made sense required an extensive conversation about what the clients wanted to achieve and the risks they were prepared to take in connection with that. This experience left him skeptical that Daugerdas was providing any genuine tax counseling to clients as opposed to selling them standard-form transactions designed simply to reduce or eliminate taxes. The firm had no one who could devote several hours to analyzing each shelter that Daugerdas sold to determine if there were a plausible business purpose or economic substance associated with it.

The partner suggested to the board and electoral committee that the firm was taking the risk of selling its good name. Daugerdas’s practice, he said, was completely independent of the firm. If it was so successful, why did he need the firm to sell his shelters and opinions except to draw on Jenkens & Gilchrist’s reputation? If his shelters were legitimate, why were clients willing to pay such exorbitant fees when they probably could get a top-tier Wall Street firm for less on an hourly basis? Furthermore, Daugerdas was a lone wolf who was not suitable to serve as the manager of a branch office. In effect, the tax partner was saying, “We can’t effectively monitor Daugerdas’s practice so we have to depend on his judgment and integrity. Are we really prepared to do that?” The firm had not been able to discuss Daugerdas with anyone at Altheimer because Daugerdas didn’t want his old firm to know he was leaving. Jenkens & Gilchrist had heard from other sources, however, that Daugerdas was brilliant, that his practice was aggressive, and that a firm needed a good supervisory system in place to ensure that he stayed between the lines.

Another complication of the negotiations with Daugerdas was his demands about compensation. It’s not clear how widely known this issue was outside of a handful of lawyers in management. Like most firms, Jenkens paid its partners a share of the firm’s overall profits. Daugerdas wanted his compensation to consist of a percentage of the revenue that he generated, at a percentage higher than the typical partner share of profits. His revenue therefore would be tracked separately from that of the firm as a whole. He also wanted his compensation to be paid to a subchapter S corporation, which is a separate entity whose income is passed through to the partner. This would require that Jenkens amend its articles to eliminate the requirement that a partner in the firm must be a licensed individual lawyer.

Daugerdas’s compensation demand was “really traumatic for the firm, a totally new idea.”¹¹ Jenkens had made special compensation deals with other laterals, with compensation based to varying degrees on business origination, revenues generated by hourly billing, collection of billings, the distinctiveness of a practice, and involvement in management. The deals were disclosed to the electoral committee that made recommendations on laterals, although the amount of some bonuses were not. Compensation and performance metrics generally were available for inspection in the firm’s “blue book.” Laney had built up something of a cadre of supporters among the laterals with whom the firm had made such arrangements. But the firm had never entered into the kind of agreement that Daugerdas was proposing.

Daugerdas insisted that he wanted a fixed percentage of revenues so that he would not have to rely on the discretion of the compensation committee. He argued that the firm’s costs for the shelter transactions would be quite low and therefore recovered by the firm from revenues fairly quickly. Anything above that would be a premium, of which he should receive a significant share. It was true that this type of compensation arrangement was unprecedented at Jenkens, but the firm had never had a high-end niche practice before. This was the cost of acquiring one, Daugerdas argued.

Durbin eventually assumed the role of Daugerdas’s champion within the firm and worked hard to convince other partners that his acquisition made sense. He discounted the concerns of Daugerdas’s main critic as based on a combination of personal dislike and a sense of being threatened by the prospect of another prominent tax lawyer joining the firm. Indeed, Daugerdas had made clear that he wanted to be the co-head of the tax practice, if not the sole head. The sense among most of the partners was that Laney was cautiously supportive of Daugerdas. At a minimum, they believed, he would have been able to stop the candidacy if he hadn’t wanted him in the firm.

The electoral committee eventually took a straw vote on Daugerdas, which indicated that a narrow majority of members were opposed to him. The firm’s board of directors was concerned enough about this sentiment that it delayed making any formal proposal to the committee. Some of the committee members were relieved and believed that the idea had been abandoned. Durbin and other supporters, however, continued their efforts to convince a majority of the partners that the firm on balance would gain significant benefits from bringing Daugerdas on board.

Over the next few months, Durbin and the board crafted an arrangement intended to address concern about the risks posed by Daugerdas’s practice. This involved having Michael Cook, a well-respected tax partner and certified public accountant in the Austin office, review and sign off on all tax opinions rendered by the Chicago office. If there were reservations about Daugerdas’s character, there were none about Cook’s. He was someone whom, as one former Jenkens lawyer put it, “everyone loved and respected,” and he had a reputation as straightforward and conservative tax lawyer. The board decided to move ahead with a recommendation to the partners that Daugerdas, Mayer, Guerin, and two other lawyers from Altheimer’s Chicago office be hired on this basis. Although the debate continued, by this point enough members were convinced that Daugerdas’s practice would be a profitable acquisition and that the firm could contain whatever risks it posed. A majority of partners voted to accept the board’s recommendation, although there was still a respectable number of dissidents.

The agreement with Daugerdas provided that he would be equity shareholder, manager of the firm’s Chicago office, and co-chairman and joint practice group leader of the firm’s Tax Practice Group along with Michael Cook.¹² The firm was required to operate as a general partnership under Illinois rules, so a professional services agreement stated that Jenkens & Gilchrist Texas was engaging Jenkens & Gilchrist Illinois to assist it in rendering services to clients of the Texas firm that it believed could be serviced by the Illinois firm.¹³ The agreement also provided that Michael Cook would “be retained as a consultant on all federal tax opinions rendered by” the Illinois firm.¹⁴ Daugerdas’s compensation would be paid to “Paul M. Daugerdas, Chartered,” a corporation that he formed to become a partner in Jenkens.¹⁵ His annual compensation for the 1998, 1999, and 2000 fiscal years would be $600,000, comprised of $480,000 in salary and $120,000 in a bonus based on certain conditions.¹⁶ In addition, “Excess Collections Compensation” would be 50 percent of the premium billings up to $5 million, and 70 percent of anything from $5 million and above.¹⁷

Mayer had sought to negotiate a deal like the one given Daugerdas, under which he would receive a percentage of the client revenues that he generated. The firm refused. Mayer therefore decided to join the firm as an income partner for the first few years because he didn’t want his bonus to be limited by the constraints on the equity partner bonus pool, which was calculated based on the revenues of the firm. He hoped, in other words, to generate revenues that would warrant a bonus that at least began to approach the kind of deal that Daugerdas had received for excess collections. Mayer’s base salary for the remainder of 1998 and in 1999 would be $250,000 and he was eligible for an annual bonus. In addition, he was to receive $25,000 on December 31, 1998, and an additional $25,000 on July 1, 1998.¹⁸ Guerin joined the firm as an equity partner at a salary of $200,000, and was also eligible for an annual bonus.¹⁹

The agreement between Jenkens & Gilchrist and the former Altheimer lawyers became effective on December 29, 1998. Two other lawyers from Altheimer involved in corporate merger and acquisition work also joined Jenkens along with Daugerdas, Mayer, and Guerin. They, along with support staff, formed the Chicago office of Jenkens & Gilchrist a few blocks away from Altheimer & Gray’s office.

The debate within Jenkens over Daugerdas illustrated the subtle shift in norms that was occurring within the legal profession in general and among tax lawyers in particular. Tax shelter work had traditionally carried a stigma within the tax bar because it was seen as inconsistent with the way that a genuine professional should approach tax practice. Seen in this light, shelter work raised issues of honor and professional reputation. Many tax lawyers expressed this perspective when they suggested that Jenkens would be selling its good name if it admitted Daugerdas into the firm. By contrast, other lawyers—including at least some tax partners—framed their concern in less normative terms. For them, Daugerdas’s practice posed the risk that one or more of his shelters would be held invalid and that a client would have to pay taxes he thought he had avoided. The client might then sue the firm for malpractice, claiming that its lawyers should have known that the shelter would not withstand a challenge.

For these lawyers, the relevant questions therefore were how much the firm could reduce this risk through due diligence and whether it had enough insurance to pay for any claims that were brought against it. The firm assured its insurance carrier that it could minimize its risk and received assurance in turn that the firm would be covered for whatever amount remained. The likelihood of a malpractice action stemming from Daugerdas’s work was seen as similar to the type of risk that any other practice area posed, which the firm felt that it could handle with appropriate diligence. Jenkens had enjoyed success in bringing in a substantial number of laterals over the past several years. This gave management confidence that it could smoothly manage the arrival of Daugerdas with the arrangement it had devised. For supporters of Daugerdas, the decision whether to hire him required a sophisticated cost-benefit analysis, not deliberation about professional values. Their sense apparently was that things had changed enough within tax practice that any reputational fallout from hiring Daugerdas would be minimal.

A Bump in the Road

Shortly after Daugerdas began at Jenkens, the firm found itself in the middle of a controversy between Daugerdas and Altheimer. On the day he left Altheimer in late 1998, Daugerdas approached a senior partner of the firm and proposed that Daugerdas and the firm execute mutual releases of claims in connection with his departure. When the partner expressed puzzlement about what claims Daugerdas might have against the firm, the latter falsely said that he had a religious discrimination claim that he would be willing to drop.

The partner refused to provide the release and ordered an investigation into the outstanding client fees that Daugerdas was attempting to take from Altheimer to Jenkens. This led to the discovery in early 1999 that Daugerdas, Mayer, and Guerin stood to collect over $30 million in tax shelter fees for work they had conducted for Altheimer clients in 1998. Daugerdas would receive considerably more under his compensation agreement with Jenkens than his agreement with his former firm. Altheimer pressed Jenkens for the return of these fees. Daugerdas maintained that the opinions for these transactions were not prepared until after he came to Jenkens, and insisted that Altheimer had no claim to them. Eventually, however, Jenkens paid $8 million to settle the claim. The controversy was not regarded as a red flag at the time, since it was not uncommon for there to be disputes over the allocation of fees involving lawyers who went from one firm to another.

One aspect of the incident was more unsettling. Daugerdas had known of the outstanding $30 million in fees when he approached Jenkens. He had nevertheless estimated to the firm that he would generate annual revenues of only six to eight million dollars. Had Jenkens been apprised of the larger figure at the time Daugerdas approached it, the firm might have wondered how aggressive the practice needed to be to generate such enormous fees. If the shelters were legitimate, Daugerdas presumably would have encountered competition from other firms and would have had to charge lower fees. It’s conceivable that Jenkens may then have scrutinized Daugerdas’s practice more closely. At a minimum, the firm might not have accepted a compensation arrangement with Daugerdas under which he would be entitled to 70 percent of all revenues he generated over $5 million. Admitting someone who generated that much in revenues would surely shift the balance of power within the firm, and tie its fortunes closer to a single partner than the firm might want.

The firm could have revisited its earlier decision in light of this new information from the Altheimer & Gray claim about the magnitude of the revenues that Daugerdas was likely to generate. At a minimum, it could have reevaluated how well it was organized to manage the risks of Daugerdas’s practice with just one lawyer in Austin providing a second opinion. The volume of opinion letters was likely to be much larger than the firm had originally anticipated, which meant that it could be a challenge simply to keep up with them, much less give them close scrutiny. Reconsidering such issues, however, would have been uncomfortable and potentially disruptive. It was also now clear that the cost of turning Daugerdas away, or even constraining his activities, could run into the tens of millions. The easiest course was simply to move along as planned and let Daugerdas work his magic.

The Shelter Factory

From the start, Daugerdas’s tax shelter work was the focus of the Chicago office. As one former associate remarked, the office was built “on his visions, his ideas.”²⁰ Daugerdas and his colleagues had built up an extensive network of people in organizations such as accounting and financial advisory firms who referred clients to them seeking to reduce or eliminate taxes on income they expected to receive from the sale of a business or from other sources. One important source of referrals was the accounting firm BDO Seidman, based on the relationship that Daugerdas had developed with Robert Greisman of BDO shortly before Daugerdas left Altheimer & Gray. This led in late 1998 to the beginning of collaboration with BDO’s Tax Solutions Group in selling shelters to BDO clients, described in chapter 7. Jenkens generally charged the clients a fee of 3 percent of tax losses that could be used to offset capital gains and 4 percent of the desired tax loss for ordinary income. The firm paid their referral sources anywhere from 20 to 50 percent of the fees they received. When they made such referral payments, Jenkens typically increased the fee to the taxpayer to 4 percent of capital losses and 5 percent of the ordinary losses.

What exactly was Daugerdas selling? The shelters on which he and his colleagues worked were mainly variations on the Son of BOSS shelters described in chapter 4. The shelters designed by Daugerdas involved, at their core, selling and purchasing offsetting options. As with the other Son of BOSS shelters, the tax benefits were based on the claim that selling an option should be treated differently under the tax code from the cost incurred to purchase one. The options that Daugerdas used initially were options to purchase Treasury notes as part of a shelter that he had developed at Arthur Andersen and had been selling at Altheimer. He discontinued this shelter in October 1999, however, when it looked like Congress would clarify the law to eliminate the tax advantage that it supposedly provided.

At that point, Daugerdas switched to the Short Options Strategy (SOS), which involved the use of options based on movements in currency exchange rates. SOS generated the largest amount of tax losses during the time Daugerdas was at Jenkens & Gilchrist. In 1999 and 2000, it was sold to about 550 clients, who claimed to avoid a total of $3.9 billion in taxes. In addition, a shelter known as the Swaps shelter was sold to at least fifty-five individuals and generated more than $420 million in supposed tax losses, while a Hedge Option Monetization of Economic Remainder (HOMER) shelter was sold to at least thirty-six individuals, generating more than $400 million in ostensible tax losses. Precise figures are not available on Daugerdas’s Treasury shorts shelter sales while at Jenkens, but his indictment indicated that the shelter was sold from 1994 to 1999 to at least 290 taxpayers who claimed $2.6 billion in losses for tax purposes. Finally, the Jenkens Chicago office sold the COBRA version of SOS that Daugerdas had first pitched when in talks about joining the firm. Some idea of the losses that COBRA generated is reflected in the fact that the firm settled a class action brought by purchasers of the shelter for around $81.5 million in January 2005.

The Treasury short sales, along with SOS and its COBRA variation, involved transactions designed to increase a taxpayer’s basis in an asset while avoiding rules that otherwise would operate to reduce the basis. The effect was to generate a loss for tax purposes when the taxpayer sold an asset for less than the amount of the basis—even though the taxpayer suffered an economic loss nowhere near the loss that she claimed for tax purposes.

To illustrate this, suppose that a taxpayer sells a call option, which means that she agrees to sell to a party the option to purchase from the taxpayer, say, 100,000 euros for $150,000. That is, taxpayer agrees to sell 100,000 euros at an exchange rate of $1.50 to the euro. Assume that the option remains available for two weeks. The buyer of the option believes that the value of the euro will go up during this period, which would enable her buy the euros for $150,000 and sell them for more. The buyer is willing to pay $2 million for the call option. If the value of the euro instead falls below $1.50 over that period, the buyer will not be interested in buying euros at $1.50 each and will simply let the option expire. In any event, the taxpayer who sold the option keeps the $2 million profit on the transaction.

There is a possibility, however, that the price of the euro may rise within two weeks so the taxpayer must have 100,000 euros available to sell to the buyer of the call option. She therefore buys a call option for herself to purchase 100,000 euros at a rate of $1.50 per euro, which expires in thirteen days. She pays $2,001,000 for this option, which ensures that she will have the euros necessary to meet her obligation to the buyer of the first call option on the next day if the need arises. She pays $2,001,000 for this, which is $1,000 more than she received when she sold the first call option. She therefore has suffered a net economic loss of $1,000 in the two transactions.

The next step in the transaction involves using a partnership to claim a loss considerably higher than the $1,000 actually lost. The taxpayer forms a partnership with a friend and contributes to it both the call option she bought and the one that she sold. The one she bought is an asset valued at its $2,001,000 purchase price, so the amount of this contribution becomes her basis in the partnership. The one she sold represents her obligation to sell 100,000 euros at $1.50 per euro if the buyer makes this demand. This is a liability for which she is responsible, which is valued at its $2 million purchase price. Partnership rules say that when a person transfers a liability to a partnership, as the taxpayer did here in transferring the call option that she sold, this relieves the individual of the liability. This benefit is treated for tax purposes as a distribution of money by the partnership to the partner. Such a distribution in turn reduces the partner’s basis in the partnership by that amount. In this example, the taxpayer’s $2,001,000 basis representing the call option that she purchased and then contributed to the partnership should be reduced by $2 million, which is the value of the call option she sold for which she has liability, which she contributed to the partnership. The result is that the taxpayer’s basis in the partnership after her contributions is $1,000.

Most of the shelters on which Daugerdas and his colleagues worked, however, were predicated on the claim that the liability in this example was contingent—it might never arise. They argued that for tax purposes this contingent liability should not be treated as a definite liability that reduces the taxpayer’s basis in the partnership. This means that the taxpayer claims a basis of $2,001,000. The partnership then makes a payment to terminate its call obligation and accepts a payment to terminate its option to buy shares, which results in net proceeds of $1,000. The partners next liquidate the partnership and share the proceeds between them. Assume that the taxpayer’s share of the proceeds is $500. Subtracting this amount from the basis that she claims in the partnership, the taxpayer then claims a loss for tax purposes of $2,000,500. She uses this to reduce her overall taxable income by this amount—even though her actual economic loss from these transactions is $500. This represents her $1,000 loss from the sale and purchase of the options, minus the $500 she received when the partnership was liquidated.

Promoters of the shelter claimed, and Daugerdas and his colleagues opined, that this tax treatment of the transaction likely would be upheld if challenged. The rationale for this assertion was that the treatment of the liability as contingent was consistent with tax law as declared in Helmer v. Commissioner,²¹ a 1975 U.S. Tax Court case described in chapter 4. To reiterate the basic facts of that case, a partnership received periodic payments to keep open an option to buy partnership property. In the event that the party with the option elected to exercise it, these payments would be deducted from the purchase price. Taxation of the payments to the partners was deferred until either the option expired, in which case they would be taxed as ordinary income, or the option was exercised, in which case they would be taxed as part of any capital gain that the partners enjoyed from the sales price that they received. The partners claimed that granting the option created a partnership liability that should be included in their basis in the partnership, which in turn reduced their tax obligation. The Tax Court disagreed, observing that no obligations accompanied receipt of the option payments. The payments did not have to be returned if the option terminated and would be applied against the purchase price if the option were exercised. Recognition of the payments as income was deferred only to determine whether they would be taxed as ordinary income or capital gains, not because the payments created any obligation to repay the funds or to perform any future services in order to keep them.

Daugerdas and his colleagues took the position that Helmer stood for the proposition that any liability that is “contingent”—that is, that may not arise or whose amount cannot be calculated at the time it is incurred—should not be included in the calculation of a taxpayer’s basis. In the preceding example involving euros, it is possible that the taxpayer’s obligation under the call option that she sold might never arise, since the purchaser would let the option expire if the price of the euro went down. It is thus inappropriate to reduce the taxpayer’s basis by her obligation to sell the euros to the option purchaser for $1.50 per euro, the value of which is represented by the $2 million the purchaser paid her for the option. In Helmer, tax law precluded using a putative liability to increase a taxpayer’s basis; Daugerdas claimed that it also precluded using a putative liability to reduce a taxpayer’s basis.

In each instance, of course, the taxpayer is attempting to maximize the amount of her basis. In Helmer, the taxpayers sought to do so by claiming that a noneconomic liability should be counted for tax purposes. In the example involving euros, the taxpayers are attempting to do so by claiming that an economic liability should not be counted for tax purposes. Both efforts represent attempts to claim tax treatment at odds with economic reality. Reading Helmer in light of the court’s underlying purpose should lead to including the call option obligation in the taxpayer’s basis and then subtracting it from the basis when the option is contributed to the partnership. Daugerdas claimed, however, that the literal terms of the court’s holding in Helmer, not its rationale, should govern. Jenkens & Gilchrist issued a lengthy opinion concluding that the tax treatment of the options transaction more likely than not would be upheld if challenged by the IRS.

The risk always exists, of course, that the tax consequences of a transaction that complies with the letter of the law will not be honored because the taxpayer had no nontax business purpose for entering the transaction or the transaction had negligible economic substance. In the euro example, the simultaneous purchase and sale of virtually offsetting options has the net effect of costing the taxpayer $1,000. If the price of the euro goes above $1.50, she is entitled to buy the euros at $1.50 each to meet her obligation to sell them at the same price to the party to whom she sold the option. If the price of the euro goes below $1.50, the option buyer will have no interest in purchasing them at that price, nor will the taxpayer. Both options will expire. It is hard to imagine any nontax business purpose an investor would have for entering into two transactions that ultimately have such negligible economic substance.

COBRA Unveiled

The COBRA variation of the SOS that Daugerdas designed and marketed at Jenkens & Gilchrist in collaboration with Ernst & Young (E&Y), discussed in chapter 6, was designed to provide an ostensibly more plausible argument that the purchase of offsetting options had a nontax business purpose and possessed economic substance. E&Y needed a legal opinion, however, that the shelter more likely than not would be upheld if challenged. E&Y was aware of the shelter work going on at Jenkens & Gilchrist and asked Grady Dickens at the Dallas law firm of Scheef & Stone for an introduction to the firm. Dickens knew Patrick O’Daniel, who worked with Michael Cook at Jenkens; Dickens put O’Daniel in touch with Robert Coplan and other E&Y partners. O’Daniel in turn got Daugerdas involved. Scheef and Jenkens then entered into a fee agreement under which Scheef would receive 20 percent of the fees that Jenkens received on each E&Y shelter, as compensation for “provid[ing] legal services” to Jenkens in connection with Jenkens’s preparation of legal opinions.²²

Jenkens and E&Y worked together to refine COBRA, and Daugerdas suggested that they use Deutsche Bank to perform the currency trades necessary to produce the tax loss from the shelter. The shelters were marketed out of the Jenkens & Gilchrist Chicago office. In all but one of the COBRA transactions involving E&Y, Jenkens created the necessary entities and wrote the legal opinion. Because E&Y was concerned that the Jenkens opinion might not be regarded as sufficiently independent in light of the firm’s role in designing the shelter, they arranged for an additional opinion from R. J. Ruble of Brown & Wood. Each opinion letter was virtually identical. E&Y insisted that each taxpayer sign a confidentiality agreement not to disclose the marketing material to any outside parties, including any attorneys. In these agreements, Jenkens expressly disclaimed any fiduciary responsibility to the taxpayers.

The COBRA shelter was a digital option. It involved not simply a bet that the price of a currency would go up or down, but that it would be at a specific value by a certain date. A COBRA sold to one investor, whom we’ll call John Smith, illustrates the shelter’s basic features. Smith was advised to enter into a transaction that involved purchasing options based on the exchange rate of the euro to the English pound. When Smith entered into the transaction, the rate was $1.6024 to the pound. He paid $10 million for a put option at a strike price of $1.6024 to the pound. If the euro were at this or a lower price, Smith would be entitled to a payment of $20 million from Deutsche Bank. At the same time, Smith sold a call option to the bank for $9.5 million with a strike price of $1.6022 to the pound. If the euro were at this or a lower price on the same date, he was obligated to pay Deutsche Bank $18.5 million. Thus, on the expiration date of the options, if the pound traded at less than $1.6022, Smith would have the right to receive $20 million from Deutsche Bank while owing it $18.5 million, which would result in a gain of $1.5 million. Of course, to obtain this he had to have purchased one option for $10 million and sold another for $9.5 million and pay a fee that was about 4.5 percent of the $10 million he purchased, or $450,000. He thus would have paid a net total of $950,000 to gain $1.25 million, which would put him $75,000 ahead. Estimates were that the likelihood of this occurring was about 30 percent.

If the pound were trading above $1.6024 on the expiration date of the options, Smith would have no interest in selling the pound at $1.6024 to the pound and Deutsche Bank would have no interest in selling the pound to Smith at an exchange rate of $1.6022. Thus, neither party would be entitled to any payment from the other. Smith then would simply have incurred his net payment of $950,000. Estimates were that there was a 65 to 70 percent chance that this would occur. Whichever way the exchange rate moved, it would be hard to argue that Smith had a nontax reason for entering into this complex series of transactions.

Jenkens & Gilchrist and E&Y nevertheless maintained that Smith stood to gain $20 million from his investment if the exchange rate dropped below $1.6024 but above $1.6022. If this were to happen, Deutsche Bank’s obligation to pay Smith $20 million would be triggered but Smith’s obligation to pay the bank $18.5 million would not. There was as much as a 5 percent chance, they argued, that this could occur. This was referred to as the “lottery feature” of the shelter. A taxpayer, in other words, was taking a gamble that she might get lucky and reap a $20 million windfall for her $950,000 investment.

Even if we assume the most optimistic odds of 5 percent that this could occur, a straightforward expected value analysis would indicate that paying $950,000 for this chance is not a good idea. There was a 30 percent chance that the exchange rate would drop below $1.6022 and the taxpayer would net $75,000, for an expected value of $22,500. There was a 65 percent chance that the rate would rise above $1.6024 and the taxpayer would lose $950,000, for an expected value of $617,500. Finally, there was a 5 percent chance that the rate would fall between $1.6024 and $1.6022 and the taxpayer would receive $20 million, for an expected value of $1 million. All together, the three expected values come to $607,000. This obviously is less than the $950,000 the taxpayer would have to pay to enter this lottery in the first place. Keep in mind that this figure reflects the most optimistic assessment of the chance of winning the lottery; the odds in most transactions were virtually negligible. Indeed, the likelihood was so remote that the Deutsche Bank foreign currency desk didn’t even bother hedging its supposed $20 million exposure on any transaction.

There was another even more fundamental reason that the lottery feature didn’t infuse the COBRA with economic substance—Deutsche Bank would not allow it to be triggered. There is never a single foreign currency rate throughout the world. Rather, different institutions offer similar but slightly different rates at any given time. As a complaint filed by investors later described, for instance, there were twelve spot rates listed as of 8:21 a.m. on May 8, 2003, ranging from $1.1463 to the euro to $1.1468 to the euro. Deutsche Bank was authorized to decide which exchange rate would be used at the precise time specified in the contracts. This enabled it to ensure that the exchange rate never hit the narrow “sweet spot” that would trigger a large payout to the taxpayer.

The reason for entering into the COBRA transactions, of course, was to reduce or eliminate taxes. Before the options expired, Smith contributed both his put option and his call obligation to a partnership. The put option was valued at its $10 million purchase price and became Smith’s basis in the partnership. The call obligation, however, was treated as a contingent liability so that transferring it to the partnership was not treated as relief from a liability and the $9.5 million that Smith received for it was not subtracted from his basis. Smith then contributed a small amount of cash to the partnership. When the options expired, the partnership bought a small amount of currency. To reduce it to essentials, the currency was sold at a price far less than Smith’s $10 million basis in the partnership. The difference of close to $10 million was recorded as a loss for tax purposes, even though Smith actually had incurred a loss of only the $500,000 difference between the $10 million he paid to buy his put option and the $9.5 million he received for selling the call option.

IRS Notice 2000-44, issued in August 2000, described a transaction in which a taxpayer buys and sells options and then contributes them to a partnership: “Under the position advanced by the promoters of this arrangement, “the taxpayer claims that the basis in the taxpayer’s partnership interest is increased by the cost of the purchased call options but is not reduced . . . as a result of the partnership’s assumption of the taxpayer’s obligation with respect to the written call options.” This, of course, described COBRA and other similar shelters. The notice continued, “The purported losses resulting from the transactions described above do not represent bona fide losses reflecting actual economic consequences. . . . The purported losses from these transactions (and from any similar arrangements designed to produce noneconomic tax losses by artificially overstating basis in partnership interests) are not allowable as deductions for federal income tax purposes.”²³

Jenkens lawyers discussed this notice but ultimately told previous purchasers of shelters that it was legally inapplicable to them and did not affect the propriety of their COBRA transactions. As one letter to an investor said, “One of the described transactions in Notice 2000-44 bears similarities to the transactions described in our enclosed opinion. While 2000-44 sets forth the IRS position on these transactions, the Notice does not change the existing law which is relied upon in our enclosed opinion and does not change our conclusions as stated in such opinion.”²⁴

Standard Operating Procedure

Any claims of business purpose or economic substance to the shelters that Jenkens sold were belied by the uniform steps in the transactions, the virtually identical legal opinions that the firm issued for all the taxpayers, and the absence in most cases of any contact between the firm and the taxpayer. The experience of investor Henry Camferdam was typical of the people who purchased COBRA from Ernst & Young. Camferdam and three colleagues were founders of an Indiana company known as Support Net, which distributed mainframe computer systems and peripheral devices. Ernst & Young provided accounting, auditing, and consulting services to the company and two of the individuals through its Indianapolis office. When the owners sought to sell the business, they retained E&Y to help market and sell it.

The business was sold in 1997 and the founders were scheduled to receive a final payment in August 1999 that represented a combined capital gain of $70 million for the four of them. In late October, Wayne Hoenig, senior manager of the E&Y Indianapolis office, called Camferdam about a strategy that could wipe out his portion of the capital gains from the sale of the business. Camferdam suggested that he and his three colleagues meet to hear a presentation of the strategy. Hoenig told him that they needed to start the transaction within the next week to ten days because it took about six to eight weeks to complete and needed to be done before the end of the year. Before receiving any more details about the shelter, the four businessmen had to pay E&Y a nonrefundable fee of $1.056 million and sign a nondisclosure agreement. They then formally retained E&Y as accountants and tax advisors for COBRA transactions.

In early November, the four men met with Hoenig and two of his colleagues at the E&Y office in Indianapolis. They were told in the course of a PowerPoint presentation that E&Y and Jenkens & Gilchrist had developed a tax strategy for a select group of individuals who had sold large businesses or enjoyed large capital gains. The strategy, the E&Y representatives said, took advantage of a “loophole” in the tax law that served to shelter most or all of their gains from any tax liability.²⁵ They said that the E&Y regional office had already implemented five of these transactions, which were being offered only to taxpayers with gains in excess of $50 million. The four men then were given a form to fill out indicating how much of a loss they wanted to create.

E&Y then showed the men an opinion letter from Jenkens & Gilchrist that E&Y said would provide “insurance” in case of an audit.²⁶ Camferdam and his colleagues were not told that Jenkens had helped design the shelter. They were told, however, that they should obtain a second legal opinion “just to make sure,” and that the firm of Brown & Wood could provide one.²⁷ Hoenig told the four men that they needed to have a “business purpose” for entering into the transactions. The men didn’t understand the transaction and asked Hoenig to figure out a business purpose, which he agreed to do.²⁸

A few days later, Hoenig and other E&Y representatives met with the four men on a golf course before three of the latter were about to start a round of golf. Hoenig had told the men that getting the transactions underway was urgent and asked to squeeze in the meeting just before tee time. Hoenig had picked the loss that the parties needed to generate and needed them to sign all the necessary paperwork, including transaction documents. The meeting lasted no more than half an hour. The taxpayers received no copies of the documents but were told that the paperwork would be mailed to them. During the meeting one of the men asked Hoenig, “What is the strategy?” Hoenig replied, “It[’s] already done; don’t worry about it.”²⁹ The fee for the shelter would be 4.5 percent of the capital loss created, or $3.15 million. E&Y would receive $1.05 million, with Jenkens earning $2.1 million.

Camferdam and his colleagues were then instructed by Deutsche Bank which currencies to choose for purposes of entering into the purchase and sale of options. The bank advised Camferdam to choose the euro and the other three men to choose the Japanese yen. They were then told the exact amounts of each option and the amount of the premiums that they would pay and receive for each. Camferdam, for instance, was told to purchase an option on November 16, 1999, that pegged the value of the euro at $1.0187. If the price was at or below that amount one month later, at 10:00 am New York time on December 16, the bank would pay Camferdam $100 million. Camferdam paid a $50 million premium for this option. He was instructed simultaneously to sell an option to the bank that pegged the value of the euro at $1.0186. If the euro were trading at or below that price at 10:00 am New York time on December 16, Camferdam would pay Deutsche Bank $93.75 million. He received $47.5 million as payment for this option, leaving him with a net premium cost of $2.5 million. Camferdam thus would be entitled to $100 million from Deutsche Bank without having any obligation to it if the euro was worth between $1.0187 and $1.0186 at the appointed time. The bank’s ability to select the exchange rate used to determine the parties’ obligations ensured that this would never happen.

Camferdam’s colleagues were instructed to enter into similar purchases and sales of options with respect to the yen. The four then contributed their buy and sell contracts to a partnership. They counted as their respective bases the amounts they had paid for their options, but treated their liabilities on the options they had sold as contingent. These liabilities therefore were not taken into account in determining the taxpayers’ bases. The taxpayers next contributed cash to the partnership to purchase a small amount of stocks or currencies. They then transferred their partnership interests to an S corporation, which for tax purposes was treated as a partnership. This terminated the partnership and the corporation then sold the stock or currencies for an amount substantially lower than the taxpayers’ basis. The businessmen claimed losses for tax purposes of $50 million, $12 million, $7 million, and $1.4 million, respectively. Not surprisingly, this roughly equaled the amount of the capital gains that they had enjoyed from the sale of the business.

All of this may have seemed too good to be true, but Camferdam and his business partners had used Ernst & Young for years and trusted the firm. E&Y had been their company’s main source of financial guidance and business advice, working closely with Support Net across all its operations. As the outside auditor for the company, E&Y attested that its financial statements presented a fair and accurate picture of its condition. Furthermore, the firm advised the businessmen on the sale of their company and helped effectuate it. When Ernst & Young told Camferdam and partners that they could avoid taxes by entering into these transactions, they had no reason to doubt it. The firm, in other words, exploited the relationship that it had built over the years as a trusted advisor.

The transaction with Camferdam and his colleagues made apparent that investment deals constructed around COBRA and other shelters were driven solely by the desire to reduce or eliminate tax liability. Working backward from the loss that the taxpayer wanted to create, the price of the premium payment generally reflected the desired loss, the price that the taxpayer simultaneously received for selling a second option was only slightly less, and the options that were bought and sold were virtually offsetting. In other words, the transaction was designed to generate a large tax loss while producing a minimal genuine economic impact.

The fact that the transactions were solely tax-driven rather than the result of the particular investment strategies of individual taxpayers meant that the process of executing the transactions followed a template that could be easily replicated for hundreds of taxpayers. Paralegals and administrative assistants filled in names on a standard set of documents used to create the necessary partnerships and other corporations, obtained taxpayer identification numbers for the entities, created a brokerage account for the taxpayer in each transaction to conduct the necessary trades, and monitored the flow of paperwork through the routine steps of the transactions. The streamlined sequence of routine steps is what made possible the mass marketing of the shelters.

Similarly, Jenkens & Gilchrist issued virtually identical opinion letters with broad declarations about the motivation to enter into the shelters that were ostensibly applicable to every purchaser. The opinion provided to the taxpayer typically made the representation: “You entered into the purchase and sale of the Options for substantial nontax business reasons, including (i) to produce overall economic profits because of your belief that [currency exchange rates] would change; and (ii) your belief that the most direct way, with the most leverage, to realize gain from expected changes in currency prices was the purchase and Partnership for substantial nontax business reasons, including, but not limited to, potential diversification of the risks of certain investments, the desire to coinvest as partners with the other co-partners and for your convenience.”³⁰ The opinion represented that “[t]o the best of your knowledge, you have provided to us all the facts and circumstances necessary for us to form our opinion and the facts stated herein are accurate.”³¹ In fact, Jenkens lawyers never received any representations from purchasers about their particular circumstances or their purpose in engaging in the transactions. No client, for instance, ever asked to use a partnership as the vehicle for engaging in investments. Indeed, sometimes the firm had no contact with the client at all.

Reducing the Audit Profile

Jenkens and the other entities involved in the shelters engaged in several activities as part of a process known as “reducing the audit profile.”³² One of these was “cosmetic trading,” which consisted of executing numerous option trades on behalf of shelter purchasers to create the impression that the purchasers were actively involved in trading as an investment strategy.³³ Another activity was to identify “dog tech stocks,” which were high-tech companies that had a highly successful initial public offering (IPO) but whose stock then fell precipitously because of financial problems.³⁴ After the taxpayers contributed their option contracts to the partnership, they were instructed to invest in the stock of these companies to create the impression that the losses that the shelter purchasers incurred were based on market conditions rather than on a tax loss strategy.

Although the use of an S corporation in the shelter transactions was not a necessary step, according to Daugerdas “it was generally better to report the losses on separate tax returns, then have them flow through the S corporation. The S corporation was not essential, it was just less likely to be audited.”³⁵ When the shelters would result in a tax loss so large that the government owed the taxpayer a refund, clients were advised to adjust their W-4 forms to reduce the amount of the refund to minimize the likelihood of an audit.

Similarly, the fees to participate in the shelters typically were deductible, but some clients didn’t deduct them because they were so large that they might trigger an audit. Engagement letters also generally did not refer to the fees because of concern that their amount would be taken into account if an issue ever arose about whether the transactions had a business purpose or economic substance. For the COBRA transactions, Jenkens & Gilchrist’s legal fees were not itemized as deductions on investors’ tax returns. Rather, they were capitalized into the basis of the partnership interest, which was then included in the basis of the S corporation out of which payments ultimately were made. The ostensible rationale was that key Jenkens services were not the provision of a legal opinion, but the structuring of the partnership, document preparation, and the formation of entities. As an email from Ernst & Young stated, “The significance of this is that the returns will not force the individuals to show the large payment to J&G as a miscellaneous itemized deduction, which could be a red flag on the 1040.”³⁶

Daugerdas and Mayer also debated whether it was safer to eliminate all tax liability for a given year. Mayer thought that it might be better not to do so because the taxpayer was less likely to be audited if the returns were relatively consistent from year to year. Daugerdas, however, believed it was better to show a loss rather than report any income, on the theory that this made the IRS less likely to conduct an audit because there appeared to be little prospect of recovering revenue. Participants in implementing the shelters were “always refining” their efforts to reduce the audit profile of the shelter purchasers.

Lawyers at the firm also found it necessary sometimes to backdate documents so that investors would receive the tax losses they sought. One wealthy taxpayer who owned car dealerships engaged in a Treasury short sale to shelter $20 million from the sale of stock. The Jenkens & Gilchrist lawyers discovered that certain documents were dated one day too late, which resulted in the taxpayer having unintended taxable income. They agreed to backdate the documents so that the client received the tax benefit he was seeking. Similarly, another client failed to sell enough stocks in 1999 to trigger the desired tax loss. Mayer approached the taxpayer’s broker at Deutsche Bank in the spring of 2000 and asked him to sell stock to the taxpayer but to record the sale as occurring in 1999. This was done, and the opinion letter for the transaction didn’t mention the discrepancy.

On another occasion, a group of tax shelter clients sought to shelter substantial income that they expected from the sale of stock. The value of the stock dropped unexpectedly, however, so that the short sales in which they engaged resulted in gains rather than in the intended losses. To obtain the loss that the taxpayers wanted, Mayer agreed to alter the date on the document assigning the options to a partnership. He whited out the November 5, 1999 date and inserted November 15, 1999 in its place. Mayer discussed this with Daugerdas and Guerin, and all agreed on the change to keep the clients happy.

The Texas Connection

Under the arrangement within Jenkens & Gilchrist, Michael Cook in Austin had the final sign-off on the opinion letters generated by the Chicago office. Cook delegated the task of traveling to Chicago to review the client files to Bryan Lee, a partner in the Austin office. Lee periodically commented on the opinion letters and Cook relied on his assessment in providing the final signature. Lee also occasionally made presentations to prospective clients about shelter products. One email from Cook to a partner in Dallas inquiring about a shelter for a client preparing to sell a business stated, “Bryan Lee is as good as any of the three Chicago attorneys when it comes to presenting the short option strategy.”³⁷ Cook mentioned that neither he nor Lee received any business development credits for any shelter sales, but that the Dallas partner and Daugerdas would each get half of the development credit for the sale of a shelter to the partner’s client.

Daugerdas, of course, had vastly underestimated when he claimed that he expected to generate $6 million in annual revenues. In 1999, his practice produced about $28 million in income or almost five times the amount that the firm anticipated. This figure was more than 13 percent of the firm’s total revenues. In 2000, he generated almost $91 million in revenues or almost a third of Jenkens’s revenues. Over a thousand taxpayers participated in these transactions, which would have created a challenge for Cook and Lee even if they had been experienced tax shelter lawyers. Ideally, they would have had to verify every taxpayer’s motivation for entering into the transaction to ensure that it was based on the prospect of economic benefits apart from tax consequences. In addition, they would have needed to be intimately familiar with the economic substance and business purpose doctrines as applied in numerous cases to determine whether the lottery feature in each transaction constituted enough of a profit opportunity that a court likely would uphold the shelter. This was a daunting prospect under the best of circumstances, but the fact that Cook and Lee were traditional tax lawyers with no experience in tax shelters virtually doomed the oversight process from the start. Despite the weaknesses in the process, there is no indication that either Cook or Lee asked for additional resources or declined to participate in signing off on the shelter opinions.

Exacerbating the problem, Daugerdas repeatedly locked horns with Cook over whether the tax shelter work accorded with the latest court rulings and IRS pronouncements. “I would regularly get a read that it was increasingly unpleasant dealing with Daugerdas,” recalled Laney. “It was a very difficult interaction, and it grew increasingly difficult. Mike would say, ‘No, you can’t do it this way.’ Paul didn’t like to have his opinions tinkered with.” Roger Hayse, former chief operations officer of the firm, observed of Daugerdas, “His attitude was that his view was the definitive one, and if you didn’t agree with him, it was because you simply didn’t understand him.”³⁸

The huge volume of transactions also made it daunting to complete them in time for taxpayers to claim tax benefits before the year ended. Jenkens lawyers from Texas periodically were sent to Chicago to reduce the backlog of opinions the Chicago office faced because of the volume of shelter activity. One email from Guerin to Jenkens lawyer Patrick O’Daniel in Austin, for instance, refers to an “opinion preparation training session” for eight Jenkens lawyers who would be arriving at the Chicago office.³⁹ Guerin explained the steps in the transactions and how certain entities were used to minimize the likelihood of an audit. What the Texas reinforcements mainly did, however, was fill in information on the standard transaction documents and opinions about each of the taxpayers and the transactions in which they participated.

The Money Flows In

With the infusion of profits from Daugerdas’s practice, Jenkens & Gilchrist ended 1998 with gross revenue of $140 million and profits per partner of $390,000. Those figures jumped dramatically in 1999, when gross revenue increased by 43 percent to $200 million, and the firm moved from 77 to 57 for this metric in the Am Law 100 ranking. Even more important, profits per partner increased in 1999 by 36 percent to $530,000. This moved the firm up 17 places in the Am Law 100, from 79 to 62. It also placed comfortable distance between Jenkens and its main Dallas-based rival, Locke Liddell & Sapp, which vaulted into the Am Law 100 for the first time in 1999. Daugerdas had dramatically boosted Jenkens’s odds of realizing its ambition to become a major national—and possibly international—law firm. Indeed, in late 2000 the firm entered the New York market by merging with the firm of Parker Chapin.

From 1999 through 2002, Jenkens & Gilchrist received $230 million in fees from Treasury short sales, SOS, and other shelters. Other entities affiliated with the shelters earned an additional $148.2 million. Of the Jenkens amount, Daugerdas received $95.7 million, Mayer $28.7 million, and Guerin $17.5 million. That left $88.1 million for the firm. This amount appears not to include revenues from the COBRA shelter, which the IRS estimated had been sold to 600 individuals. The Jenkens board of directors memo to partners at the end of 1999 described the year as “spectacular,”⁴⁰ and said, “With special recognition and thanks to the extraordinary contribution from our Chicago office, congratulations to all of you.”⁴¹ The board sent a similar memo to members of the firm at the end of 2000 congratulating them on Jenkens & Gilchrist’s strong financial performance for the year.⁴² The memo named Daugerdas and Mayer as the top business generators, and Guerin, Lee, and Cook as providing support for them.

Daugerdas had agreed with Mayer and Guerin that he would pay them bonuses out of his own pocket if he felt that Jenkens was not compensating them as they deserved. When the lawyers moved to Jenkens from Altheimer, Mayer didn’t have a track record of generating business and wasn’t going to be compensated on that basis. He therefore had an agreement with Daugerdas that the latter would get credit for 50 percent of Mayer’s deals, which funded the payment that Daugerdas would make to him. Mayer eventually received $875,000 in such payments from Daugerdas. Daugerdas also agreed to make payments to Guerin, who received over 80 percent of her income from such bonuses. In 2000, for instance, Guerin’s compensation was $11.5 million, of which almost $9 million came from Daugerdas. The following year Daugerdas made a payment to Guerin of around $4 million. Guerin served as more of a service partner to Daugerdas than did Mayer, who tended to have his own clients and assistants separate from what Guerin was doing. The firm’s management was very distressed when it learned of Daugerdas’s payments to his colleagues, since this upset the compensation balance at the firm. From that point on, the firm asked Daugerdas each year if he was compensating anyone else; it’s not clear how he responded.

Daugerdas persistently lobbied management for more compensation for himself, Mayer, and Guerin. “Mr. Daugerdas believed our compensation system didn't adequately compensate the people in Chicago who assisted him with opinions,” observed Hayse. If Mr. Daugerdas felt that he was getting short-changed, added Laney, “it was like the wrath of Khan.”⁴³ A May 28, 2001, memo from Daugerdas to the Jenkens board of directors provides an example of Daugerdas’s dissatisfaction. The memo stated that, with respect to approximately $19.6 million earned in 1999 and 2000 on Ernst & Young transactions:

I disagree with the fact that almost $9.8M in development credit that was given to Associate Attorney Patrick O’Daniel, whose sole contribution was to introduce me to Scheef & Stone, who, after entering into an agreement to be compensated by the Firm, introduced me to Ernst & Young (who, after lengthy negotiations regarding structure, referred me to prospective clients). This allocation was contrary to the written policy of the Firm, the facts of the situation, and my agreement with Mr. O’Daniel. Under my agreement with the Firm, I should have received 70% of the $19.6M in financial products from the Ernst & Young transactions.⁴⁴

Daugerdas’s efforts to create tax losses were not confined to paying customers. The reason he wanted his compensation at Jenkens paid to a corporation was so he could use it to generate losses to offset his own tax liability. Each year from 1999 through 2002, he generated tax losses from shelter activity that resulted in a net loss on his tax return. In 1999, PMD Chartered received about $19.3 million in income but used Treasury short sales and SOS to produce a net loss for tax purposes of $1.02 million. In 2000, he earned a whopping $50.3 million. His corporation paid Guerin almost $9 million and he used SOS to generate a $1.3 million net loss, ending up with no tax liability. He did not pay taxes in 2001 or 2002. In 2001 he earned $19.9 million, paid Guerin $4 million, and then used SOS to create a net $1.7 million loss on his return. In 2002, as shelter work declined, his compensation was $2.8 million. He used SOS to produce a $1.5 million net loss and applied for a refund of almost $968,000. From 1999 through 2000 he created a total of $82.6 million in ostensible losses resulting from shelters he created for himself. Mayer was less ambitious but used SOS to generate almost $4 million in tax losses in 1999 and over $22 million in 2000. Mayer approached Guerin about using shelters to reduce her taxable income as well, but she replied that she “did not have the risk appetite” to do that.⁴⁵

Increasing Tension

Concern about Daugerdas within Jenkens & Gilchrist heightened when he was sued in 2000 by James Haber, president of a business engaged in designing tax shelters known as Diversified Group, Inc. (DGI).⁴⁶ Daugerdas and Haber had first met in 1992 and over the next several years Haber had asked the lawyer for his assessment of various shelters that DGI had developed. Daugerdas was entitled to market the shelters to clients and split the fees with DGI. Haber claimed that in 1998 DGI had developed a shelter known as the Option Partnership Strategy (OPS) that involved trading digital options and transferring them to a partnership to create a substantial basis in the partnership interest.⁴⁷ This shelter was identical in all material respects to COBRA. Haber alleged that he had provided information on OPS later that year to Daugerdas to help evaluate and develop the shelter. Haber maintained that their understanding was that Daugerdas would be able to market the shelter to investors as long as he obtained DGI’s consent to do so and shared the fees with the company.⁴⁸

Daugerdas was marketing the Treasury short sale shelter to taxpayers. When he discontinued doing so in the fall of 1999 because of concern about pending legislation, he shifted to using OPS instead. Haber alleged that from October 1 to December 31, 1999, Daugerdas had sold OPS to twenty-five clients and had not shared the fees from these matters with Haber.⁴⁹ Haber’s lawsuit sought $10 million in damages. Jenkens found to its annoyance, however, that Daugerdas would not cooperate with them in the litigation or any of the settlement discussions. In late March 2001, the trial court granted summary judgment motions by Daugerdas and Jenkens on two of DGI’s claims, but denied them with respect to a third.⁵⁰

DGI then sought from Jenkens production of information about the firm’s revenues from Daugerdas’s practice. The parties reached settlement only hours before a scheduled hearing on DGI’s motion to compel production of the information. Jenkens’s insurance carrier paid $10 million, and Daugerdas’s compensation was reduced by the amount of the settlement.

Shortly afterward, in an agreement dated November 2, 2001, Jenkens and Daugerdas entered into mutual releases from any obligations or claims relating to the DGI matter. “In consideration of the foregoing,” the agreement stated, the Jenkens Texas firm agreed to indemnify Daugerdas “in any action in which Daugerdas is a named defendant (or where a claim has been made against him) from any and all liability,” as well as counsel’s fees, related to any work on the Option Partnership Strategy, including legal opinions, “on and after January 1, 1999.”⁵¹ Considering that the IRS later estimated that Daugerdas sold at least 600 COBRA shelters, many of which were after January 1999, the firm was assuming a potentially substantial financial risk by agreeing to provide such indemnification.

The most disturbing aspect of the DGI litigation for Jenkens was not the dispute with DGI but information that had come out during the lawsuit that Daugerdas had hidden fees from the firm. When Daugerdas came to Jenkens, he continued work for a shelter promoter for whom he had done projects while working at Altheimer. He did a transaction in 1999 for the promoter that involved issuance of a Jenkens & Gilchrist opinion letter, resulting in fees to the firm. Under his compensation agreement, Daugerdas was entitled to a portion of those fees. Unbeknownst to Jenkens, however, Daugerdas arranged to have an additional fee of $2,270,000 for the same transaction paid by the promoter to an entity controlled by him known as Treasurex. In addition to creating tax losses to offset his compensation from Jenkens, Daugerdas generated losses that offset his Treasurex income as well. Daugerdas had testified that “Treasurex acted as an intermediary and arranged a buyer and seller to come together and was compensated for that. As part of the same transaction, one law firm I was associated with did corporate work on behalf of the purchaser, and another firm I was associated with rendered a tax opinion to the purchaser.”⁵²

Daugerdas’s disclosure of the fees paid to Treasurex, his ongoing complaints about compensation, and his sometimes contentious dealings with Michael Cook deepened concern in some quarters within Jenkens. One former partner describes a lot of “anger and frustration” within the firm about what people regarded as Daugerdas’s breach of his fiduciary duty to his partners. On November 7, 2001, five days after the indemnity agreement was signed, David Laney dictated a confidential memo to the board.⁵³ “Now that we have settled the DGI litigation,” it said, “and with his current calendar budget utility coming to a close, I propose that we now begin seriously considering and planning the termination of Paul Daugerdas’s employment with the firm, so that the Board will be positioned to deliver the message in January 2002.” The memo continued, “Paul is not qualified to continue as Office Managing Partner of the Chicago office, but more importantly, Paul is unfit to be a partner in the firm. He represents by far the highest risk practice exposure to the firm. And he represents a continuing degradation of the firm’s integrity, character, and culture.” The memo went on to say:

Without question, Paul has proven valuable to the firm from an economic standpoint, but he has also proven extremely costly from an economical standpoint—the DGI litigation was the costliest litigation from the standpoint of the firm’s settlement contribution in the history of the firm—as well as from the firm’s image and reputation in the legal and insurance industries. Fortunately, the level of his financial performance this year, and probably in future years, will not be so great as to blind us as effectively as it did in 1999 and 2000 to the character we have seen exhibited since his arrival, and particularly since the inception of the DGI litigation.

The memo concluded, “Whether Mayer and Guerin choose to stay or go should not affect the decision regarding Paul, although I presume they will move together.”

Laney asked for two straw votes from the board about Daugerdas’s future with the firm. In each case, five of the six board members favored asking Daugerdas to leave. There was some reluctance, however, to follow through at that point. One reason, Laney later said, was that it was the fourth quarter of the year and the firm was concerned about collecting on clients’ unpaid bills. The board feared that firing Daugerdas might disrupt his collection efforts and distract the entire firm. Laney stated, “We wanted to wrap up the year in good shape,” then take action the following year. The firm also consulted with its litigation counsel in the DGI matter. That led to the conclusion that it might be better to have Daugerdas inside the tent than outside. People were not sure what else Daugerdas might have done without the firm’s knowledge. As one lawyer put it, the firm decided that it “wanted to keep him close to us to make sure that he didn’t have any claims against us or throw us under the bus saying, ‘Jenkens told me to do all this.’” One final complication was that Daugerdas’s fate was becoming intertwined with a political coup within the firm. David Laney didn’t know it yet but his tenure as chair of the firm was about to end.

Durbin’s Triumph

William Durbin had been campaigning for some time to take Laney’s job. Laney had been somewhat less active in running the firm in 2000 and 2001. He had been involved in George W. Bush’s campaign for president in 2000 and had been serving as chair of the Texas Department of Transportation. He was hoping in 2001 for an appointment in the new Bush administration that drew on his expertise in transportation issues. Durbin had taken advantage of Laney’s greater focus on outside matters to begin building support within the firm.

Durbin had been courting support in particular from the Jenkens offices in New York and Chicago, as well as among more recently arrived lateral partners. The New York office had opened in early 2001 with about a hundred lawyers from Parker Chapin, but had never been fully integrated into the firm. It faced additional difficulties after the terrorist attacks of September 11, 2001, and was being kept afloat in large part because of the revenues that the Chicago office was generating. The Chicago office, of course, was dominated by Daugerdas’s practice. Durbin had continued to support Daugerdas after he joined the firm. He periodically intervened on Daugerdas’s behalf with Laney on various issues, suggesting that the firm should be sensitive to the Chicago lawyer’s concerns.

Durbin openly announced his candidacy in November 2001, the first time a challenger to Laney had arisen since Laney had assumed the presidency in 1989. One issue on which Durbin focused was Laney’s concerns about Daugerdas. Many partners had come to rely on the significant boost in compensation that the Chicago office had made possible. Daugerdas’s departure would threaten this income and the resulting reduction in profits per partner could also make the firm vulnerable to losing partners to more profitable firms. While the revelations concerning Treasurex had engendered some suspicion of Daugerdas, a number of partners still believed that the benefits of having him with the firm outweighed the risks. In addition, some partners felt that Laney had accomplished much of what he had set out to do, and it was simply time for new leadership.

Durbin approached Laney later in November and said that he had enough votes to be elected as the new president. Laney informally consulted with several partners and came to the same conclusion. At that point, he had to decide whether to wage an active campaign against Durbin to hold on to his seat. Conversations with Henry Gilchrist and other key partners led him to decide that taking such a step could generate conflict that would hurt the firm. As a result, Durbin was elected and became the new president of the firm at the beginning of 2002.

In February Laney sent a memo to the board following up on his earlier message about Daugerdas. “During the last quarter of 2001,” he wrote, “on several occasions a clear majority of the Board concluded, without taking formal action, that Daugerdas would be/should be terminated for his perceived ethical shortcomings, subject to our first awaiting the year-end arrival of his collections. . . . I see now that Daugerdas has once again been named O[ffice] M[anaging] S[hareholder] for Chicago, and as such, an E[xecutive] C[ommittee] member. Would one of you let me know what’s going on with respect to Daugerdas’ employment status.”⁵⁴ By then, the firm had decided that the best thing to do was to keep Daugerdas close rather than oust him and create a potential adversary as the government began to ramp up its enforcement against abusive tax shelters. The board took no action in response to Laney’s memo.

Jenkens & Gilchrist’s willingness to hitch its star to aggressive tax shelter work had substantially boosted its profitability, providing resources that could be used to realize its national ambitions. At the same time, the firm’s involvement with Daugerdas eventually spelled its demise. Jenkens was hardly the only firm, however, to earn outsized profits by participating in the tax shelter industry.